Hougan: ETFs Aren’t Ruining EMs

The FT’s recent article on emerging markets and ETFs raises interesting points … if only they were true.

The Financial Times has a thing about exchange-traded funds. I can’t quite figure out why, but for whatever reason, the great newspaper—perhaps my favorite—consistently attacks ETFs.

Net-net it’s a good thing. The FT’s journalists are among the best in the world, and their persistent probing has forced ETF investors to look hard at the structure.

But sometimes they aim … and miss … and the results can lead investors astray. John Authers’ recent column on emerging markets falls into this camp.

Authers’ piece, titled “Emerging Markets Are Badly Served By ETFs,” claims that by allowing investors to buy and sell emerging market ETFs, they have ruined emerging market economies.

“The raw facts are that a remarkable amount of money has been pulled out of EM with indecent haste; and that this was the first emerging market sell-off to be conducted mostly through ETFs,” wrote Authers.

“They have misallocated capital, and helped to create yet another boom and bust cycle for the emerging world when many countries had fixed deep-seated institutional problems. There are better ways to invest in emerging markets than through ETFs,” he added.

Authers’ piece is riddled with confusing and contradictory statistics. For instance, he cites Morgan Stanley data saying that ETFs “account for about $330 billion of the $1.3 trillion in emerging market equities.”

That would be a frightening number, suggesting that ETFs hold about 25 percent of all emerging market stocks.

But hold on a second. Two paragraphs later, Authers cites TrimTabs data saying that “emerging market ETFs suffered redemptions of $4.4 billion (4.8 percent of their assets) last week.”

It’s not clear how $4.4 billion is 4.8 percent of $330 billion.

(Our data suggest U.S. investors have $117 billion invested in emerging market equity ETFs, by the way.)

Worse than the percentage confusion is Morgan Stanley’s $1.3 trillion estimate for the total capitalization of emerging market stocks. MSCI—the world’s leading global index firm—puts the number at $3.7 trillion.

If you use the MSCI number, the $4.4 billion that flew out of emerging market ETFs last week represented about 0.11 percent of the total amount of money invested in emerging markets. That doesn’t sound scary at all. In fact, that sounds fairly conservative for a market that’s in the midst of a panic.

Data worries aside, what concerns me about Authers’ piece is his suggestions for what investors do to replace their emerging market ETF exposure: buy closed-end funds.

Specifically, he points out that the “Foreign & Colonial Investment Trust was investing in Brazil, Russia, India and China in the 1880s.”

That’s cool; I love old stuff.

Unfortunately, while the long-running fund may have helped finance the first railroads in India, it’s basically stopped investing in those countries: It’s currently just 8.3 percent exposed to emerging markets, according to its most recent fact sheet.

What’s worse, it charges 0.85 percent in annual fees. That’s mighty high compared with, say, 0.18 percent for the iShares Core MSCI Emerging Markets ETF (IEMG | B-98, Analyst Pick).

That kind of cost differential adds up. Authers’ beloved Foreign & Colonial Investment Trust has been running for 148 years and currently has $4.2 billion in assets. In a magnificent coincidence, if it runs for another 148 years, it will charge exactly $4.2 billion more in fees than IEMG (assuming markets are flat).

People obsess about the fact that you can trade ETFs on an intraday basis, as if that is somehow wildly different than the daily liquidity offered by mutual funds. The much bigger difference lies in costs.

Over the past decade, ETFs have made investing in emerging markets cheap and easy. Rather than worrying about the $4.4 billion that ETF investors have pulled out of emerging market ETFs in the past week, Authers might want to look at the $330 billion he says (or the $117 billion we say) ETFs have brought in to emerging markets over the last 10 years.

At the time this article was written, the author held a long position in IEMG. Contact Matt Hougan at [email protected].